Caveat Emptor — Fiduciaries Beware New Fee Disclosure Rules

Robert J. Rafter

By Robert J. Rafter and Dorann J. Cafaro

[Editor’s Note: In light of a recent Wall Street Journal article about service provider fee disclosure, we thought it would be helpful to post the following article by Robert Rafter and Dorann Cafaro. This article lays a foundation for advisors and plan sponsors to understand the DOL rules and the broader fiduciary implications of fee disclosure:
• what the law says,
• what the courts say,
• what plan sponsors need to do near term,
• why the plan’s value proposition is important,
• why benchmarking fees is necessary,
• what plan sponsors should know about their fee disclosure responsibilities, and
• how to construct a fiduciary process for determining if plan fees are reasonable.

The article was published in the BNA’s Pension & Benefits Daily in June, and thus is written from a prescriptive point of view. Despite the fact that the compliance deadlines are now past, the action plan set forth remains viable and valuable.]

The U.S. Department of Labor is on a mission to provide better information to both plan sponsors and participants about plan expenses. It has issued three sets of related rules — (1) annual reporting and disclosure regulations to be reported on Form 5500 Schedule C; (2) plan service provider to plan sponsor fee disclosure regulations; and (3) plan sponsor to participant fee-disclosure regulations.

At the heart of these new rules is the need for plan sponsors and other fiduciaries to discover and clearly understand whether plan fees are reasonable in light of the services provided. So the theme of this article is caveat emptor — buyer beware; or in this case, as the buyer of plan services, fiduciaries and plan sponsors beware!

What the Law Says

Section 404(a)(1) of the Employee Retirement Income Security Act of 1974 provides that a fiduciary shall discharge his/her duties with respect to a plan solely in the interest of the participants and beneficiaries. In addition, the statute states that fiduciaries must act for the exclusive purpose of (1) providing benefits to participants and their beneficiaries, and (2) defraying the reasonable expenses of administering the plan. This provision is commonly referred to as the ‘‘exclusive benefit rule’’ and contains the embedded ERISA duty of loyalty. Any form of self-dealing is clearly a breach of this duty of undivided loyalty.

This exclusive benefit rule is the foundation for the Labor Department’s fee disclosure regulations that will be discussed below. It also provides a framework under which plaintiffs’ attorneys can bring successful excessive-fee class action litigation.

This article will address both the litigation and the regulatory environment. More importantly, however, this article seeks to provide the plan sponsor with a process for seeking the truth about fees, comparing those fees with appropriate benchmarks, and in the end being able to state and support that these fees are indeed reasonable under ERISA Section 404(a)(1).

To successfully ward off potential excessive-fee litigation and DOL enforcement actions, plan sponsors will need a bulletproof due diligence process to determine the reasonableness of fees.

What the Courts Say

Recently, a federal district court judge ordered ABB Inc., Fidelity Management Trust Co., and Fidelity Management & Research Co. to pay a combined $36.9 million in damages for breaching their fiduciary duty to a Section 401(k) retirement savings plan for ABB’s employees.

The lawsuit, brought by current and former employees of ABB in 2009 in the Western District of Missouri, contended that the fees and expenses paid by ABB’s 401(k) plan were too high and that the companies did not properly disclose them.

A U.S. District Court judge found that classes of investments with higher expenses were selected for the plan and that Fidelity was paid for plan services at rates higher than market costs to subsidize ABB’s corporate services. The court found that the company failed to monitor recordkeeping costs and negotiate appropriate rebates from Fidelity Management Trust (Tussey, et al. v. ABB Inc., No. 2:06-cv-04305-NKL, 52 EBC 2826 (W.D. Mo. Mar. 31, 2012)(63 PBD, 4/3/12; 39 BPR 697, 4/10/12).

The court also ordered ABB to conduct competitive bidding to choose a new recordkeeper for its plans, and ordered the parties to submit a schedule to resolve attorney fees and any other remaining issues.

In contrast, in a recent excessive-fee lawsuit, Gallus v. Ameriprise Financial Inc. (8th Cir., 2012)(63 PBD, 4/3/12; 39 BPR 707, 4/10/12), the U.S. Court of Appeals for the Eighth Circuit upheld the summary judgment granted to Ameriprise Financial. The court concluded that the plaintiffs failed to prove that Ameriprise’s 12b-1 fees satisfied the Gartenberg standard — the plaintiffs ‘‘failed to prove that 12b-1 fees were so large they could not have been the product of arm’s-length bargaining (Gartenberg v. Merrill Lynch Asset Management Inc., 694 F.2d 923 (2d Cir. 1982)). These fees were not found to be ‘‘disproportionately large.’’

Undisclosed fees and revenue-sharing arrangements have provided participants with a new set of litigation issues. Participants claim that companies have breached their fiduciary duty to monitor excessive costs. Excessive fee class actions have been filed against many major corporations in various industries including Lockheed Martin, International Paper, Northrop Grumman, General Dynamics, United Technologies, Bechtel, Caterpillar, Boeing, Exelon, and John Deere.

Some of the common issues identified by plaintiffs’ attorneys in these excessive-fee class actions include:
• fees and expenses that were and are unreasonable and excessive;
• failure to exercise the care, skill, prudence, and diligence of a prudent person;
• failure to monitor and control plan expenses, including hard dollar payments and indirect fees;
• failure to implement procedures to properly determine if fees were reasonable; and
• failure to timely disclose conflicts of interest.

Although excessive fee complaints are filed as class actions with the full intent to litigate the various claims, for the most part these lawsuits tend to get settled. A sampling of the excessive fee lawsuits reveals the following summary results:
Caterpillar — reached a $16.5 million settlement with further restrictions on use of retail mutual funds and required new procedures for hiring plan service providers.
General Dynamics — reached a $15.15 million settlement and agreed to charge future recordkeeping expenses on a per-participant basis. The company also agreed to enhance participant fee disclosure.
Hartford — agreed to a $13.8 million settlement. It was further agreed that the Hartford does not have the right to substitute other investment options for those chosen by plan sponsor.

What DOL Says

What Plan Sponsors Need to Do Near Term. Push-back from the financial industry convinced DOL to delay the April 1 effective date for its new service provider fee disclosure rules. Initial participant fee disclosure was scheduled to take effect 60 days later or on May 30. The new delayed effective dates are July 1 for the service provider to plan sponsor fee disclosure and Aug. 30 for plan sponsor to participant fee disclosure.

If plan sponsors have been procrastinating about talking to participants regarding participant fee disclosure, now is the time to speak up. Plan sponsors have essentially been given a six-month grace period in which to do what they need to do.

The participants in these plans will no doubt experience sticker shock when they get the initial fee disclosure. They cannot avoid it — up until now, many, if not most, participants in plans have been operating under the impression that 401(k) plans were ‘‘free.’’ Come Aug. 30, however, they will see the truth of the matter — perhaps for the first time. Plan sponsors are well advised to act soon and often during the next six months.

The Plan’s Value Proposition

Plan sponsors need to construct a clear and consistent communication program during the coming months so that when plan participants get their first fee disclosure, they have already digested what they are paying for and why. The idea is to very clearly get out in front of what might be perceived by the participant to be very ‘‘surprising news.’’ Set forth below is a suggested ‘‘to-do list’’ for plan sponsors:
• Obtain performance and fee information from service providers. The revised DOL rule will now require that plan sponsors fire those service providers that do not provide timely and complete fee disclosure.
• Make a determination of whether the fees are fair and reasonable and the services are necessary and cost-effective. This fiduciary standard that plan sponsors must meet is discussed below.
• Perform due diligence on fees. There are now any number of services available in the marketplace to help plan sponsors benchmark fees.
• Review the choices for participant communication on fee disclosure: summary plan description, participant benefit statements, DOL disclosure statement, email, postings, the plan website, etc.
• Structure a communication campaign — What is the message? Is it clear and concise? Does the communication campaign vision include the value proposition for the plan? Participant fees are only a problem in the absence of perceived value.
• Communicate often between now and Aug. 30 about the now-imminent participant fee disclosure — It is always better to inform participants in advance than to surprise them. The communication should speak simply, consistently, and clearly to the value of the plan, its purpose, and its services. The message should be delivered through different media at regular intervals between now and Aug. 30.
• Recognize that there will be a dramatic spike in the volume of participant inquiries.

Benchmarking Fees

It is critical that plan sponsors develop a benchmarking process to optimize investments and expenses. A well-documented benchmarking process will put the plan sponsor in the best position to effectively communicate fees.

The benchmarking process allows the plan sponsor to conduct current and effective due diligence on fees in the marketplace in a relatively short time frame. Benchmarking offers many immediate benefits to the plan sponsor. First, it allows the plan sponsor to make an informed decision to either stay with the current provider or consider a replacement, and proceed to a formal request for proposal (RFP) process.

It also permits the plan sponsor to improve its negotiating position with either its current provider or a new provider. Perhaps most importantly, it enables the plan sponsor to understand and document whether the fees are ‘‘reasonable’’ under ERISA’s fiduciary standards.

Benchmarking also allows the plan sponsor to properly justify its choice of service providers and permits the sponsor to confidently and effectively communicate fees to participants in the context of recently acquired marketplace data — summary findings can be highlighted in the participant communication campaign on fees and value.

The Best Defense is a Good Offense — The Process

Determining Whether Plan Fees Are Reasonable in Light of Services Provided. Ultimately, the plan sponsor’s fee disclosure responsibilities will become a commonplace, ongoing process. But to satisfy their fiduciary obligations under ERISA, plan sponsors must continue to remain vigilant by developing an ongoing process for determining whether plan fees are reasonable in light of the services provided.

The new DOL rules are not just about, or even primarily about, fee disclosure. Ultimately these rules are all about determining and documenting the reasonableness of the plan’s fees.

Determining reasonableness is not a new requirement. In fact, it has been the explicit fiduciary obligation under ERISA Section 404(a)(1) since 1974. However, DOL felt that many fiduciaries were unable to meet their fiduciary duty due to lack of available, clear fee information. Consequently, DOL moved to mandate proactive disclosure of compensation and fees paid for specific services as well as any conflicts of interest.

Under ERISA, fiduciaries must act prudently and in the sole interest of the plan’s participants and beneficiaries. The fiduciary rule requires reasonable contracts between employee benefit plans and the service providers performing services for the plan. The new rule is structured so that furnishing services between a plan and a party in interest to the plan will be a prohibited transaction unless it is permitted under ERISA Section 408(b)(2)’s prohibited transaction exemption, which requires that:
• the contract must be reasonable,
• the services must be necessary, and
• no more than reasonable compensation can be paid for these services.

DOL also requires that, for a service contract or arrangement to be reasonable, the service provider must disclose specified information to a ‘‘responsible plan fiduciary.’’

First Warning to Plan Sponsors. It is the plan fiduciary’s obligation to obtain and carefully consider all the pertinent information received from its ‘‘covered service providers’’; it is not the obligation of the providers. This is also true of the new Form 5500 Schedule C disclosure.

Disclosure under the new Schedule C became effective for 5500 filings during the 2009 plan year. A plan fiduciary must disclose all direct compensation, eligible indirect compensation, and ‘‘other’’ indirect compensation. The plan fiduciary must also identify the service provider and report their relationship and the fees paid from plan assets in excess of $5,000. This includes all direct fees paid from the plan or by investment vehicles. It also includes all indirect fees such as 12b-1 fees, revenue sharing, float revenue, and brokerage commissions.

Second Warning to Plan Sponsors. Schedule C should be reviewed thoroughly. By signing the Form 5500, plan fiduciaries are confirming that they have approved all these payments as reasonable and that the services were actually rendered. In addition, fiduciaries are agreeing that the value of the service was equal to the fees paid.

In March 2012 alone, DOL issued notices to 646 plan sponsors requesting clarification of Form 5500 submissions that showed mutual fund investments but no corresponding report on the Schedule C for any investment-related fees, including investment management or other fees. Be aware that the legal obligation is on the plan sponsor/fiduciary.

By signing the Form 5500, the plan sponsor/fiduciary states, under penalty of perjury, that all the information on the Schedule C is correct. Service providers are required to provide the information for Schedule C, but they may just point to the prospectus or other documents. Many times, the fees are not clearly spelled out and so it is left to the fiduciaries to determine reasonableness with limited or even incorrect information.

Determining Covered Service Providers From Which Fiduciary Must Obtain Disclosure. On top of the responsibility for the Schedule C disclosure comes the responsibility to obtain 408(b)(2) reports. The list of ‘‘covered service providers’’ is different from the Schedule C service providers. It will include any provider that has:
• a potential conflict of interest,

• is entered into an agreement to provide one or more services, or
• received or is expecting to receive $1,000 or more either from direct or indirect sources.

Step 1. Plan fiduciaries need to create a list of all possible covered service providers from which the plan would expect to receive a 408(b)(2) report. This list might include the following:
• recordkeeper of a participant directed plan s an ERISA fiduciary or a registered investment adviser (RIA or investment adviser representative)
• entities providing services directly to the plan, such as services
— to an investment contract or product holding plan assets, or
— under the Investment Advisers Act of 1940 or as an RIA.
• the broker dealer

— of an adviser acting as a broker to the plan, or

— for brokerage of a plan held at the broker dealer (not including brokerage windows or self-directed brokerage accounts).

• third-party administrator (TPA)
• anyone who was paid from indirect compensation in the plan such as the plan’s
— accountant,
— auditor,
— actuary,
— appraiser,
— attorney,
— banker or custodian, or consultants providing such services as investment policy or monitoring services or selection of investments, and
— recordkeeper.

Step 2. Plan fiduciaries need to fully understand the sources of all fees and how they are being spent. Start by identifying where the plan’s fees come from. For example, determine which fees are:
• being directly paid by the employer,
— pull together copies of invoices.
• being paid through the investment options, via
— 12b-1 fees,
— revenue-sharing,
— investment management fees, and
— custodial fees or other fees.
• being paid by the participants, through
— specific fees such as loan origination fees, qualified domestic relations fees, and investment advice fees; and
— per account administrative fees.

Step 3. Plan fiduciaries need to identify to whom the money is paid, for example:
• What is paid for administration?
— recordkeeper,
— TPA, and
— custodian.
• What is paid to the plan’s investment adviser, if applicable?
• What is paid to the plan’s investment managers?
• What money is put into an ERISA budget account, if applicable?
— A trust company report may be valuable, as it should show all money credited to the ERISA budget account as well as any bills paid from that account.

Step 4. Plan fiduciaries need to identify the nature of the service paid for.
• Was it administrative or investment-related?
• What did the provider do; what were the actual services performed?

These may be found in their contract or on their annual reports.

Third Warning to Plan Sponsors. Collecting all of this information is critical but does not satisfy the requirement determining reasonableness.

Step 5. Plan fiduciaries need to document:
• what the fees are,
• to whom they were paid,
• whether they best meet the participant’s needs, and
• whether they obtained the best value for the fees paid (DOL does not require that a plan fiduciary select a provider or an investment with the lowest fees).

ERISA also does not require that a plan use RFPs to determine reasonableness, but it does require documentation of the process used to determine reasonableness. A plan sponsor standing before a judge needs to be able to show a well-documented process for determining fee reasonableness. It is this process, and not the amount of the fees alone, that protects the plan sponsor and other fiduciaries.

Documenting the process calls for certain written information.

• Written plan minutes should clearly show the plan’s process, meaning the steps taken or to be taken to document reasonable fees.
• Gather all the written fee information for the plan, including the Schedule C and the 408(b)(2) information.
• Identify the payee and the payor for each fee.
• Attach any and all contracts or agreements showing services to be performed for the fees paid.

Benchmarking Fees. Organizing and compiling these figures will not be enough to evaluate whether these payments are reasonable. Fiduciaries will need to compare or benchmark these fees to a standard to assess reasonableness.

A benchmarking report is the documentation that the fiduciaries need to both determine and show that plan fees meet the reasonableness test. A benchmarking report must show all fees: those directly paid by the plan, those directly paid by the sponsor, and all indirect fees. The report will need to compare these fees with a statistically viable benchmarking group.

Statistically Viable Sample to Determine Reasonableness. A benchmark sampling size is statistically significant when it is large enough to accurately represent the plan benchmarking population. A benchmark group comprised of a handful of plans or a large number of plans spread far outside the basic plan factors of assets and numbers of participants will be inaccurate and may not stand up to scrutiny in a court of law.

With the possibility of litigation ever present regarding whether plan fees are reasonable, it is important for plan sponsors to protect themselves by maintaining statistically viable documentation of reasonableness. Whether such documentation is statistically viable will be crucial should a fiduciary ever need to persuade a court as to the reasonableness of its fees.

Although it may not be easy to spell out what is ‘‘statistically viable,’’ it is very easy to show what does not meet this objective — for instance, a court might find that the number of observations does not provide confidence in the plan’s findings.

Following are some guidelines to consider in determining what is statistically viable:
• Consider the number of observations used. Are there enough observations to assert accuracy? The more observations there are, the greater confidence of statistical viability there should be:
— three to five observations may be too few to provide confidence,
— even as many as 30 observations, all from the same vendors, may be viewed as too biased to give confidence, and
— even as many as 350 observations spread over extremely different profiles, such as plans with a varied number of participants, with a varied range of assets, or with different types of investments, perhaps with some employing active management and others using a significantly larger percentage of passively managed index funds, may be too misleading to provide confidence.
• The most accurate source for plan fee data comes directly from current service providers, since using RFP or request for information (RFI) fee data only reflects estimates and such estimates are often changed when the providers ultimately understand the full scope of services they will be providing.

Current accurate data delivered by the service provider may be more accurate than data from government 5500 filings in which fees may have been double-counted or information may have been incorrectly entered. Make sure the data is reliable and document its source.

Benchmark reports should not only provide a clear picture of the total plan cost comparative but also a comparative of each service provider. For example, a total plan fee examination or benchmark might reveal that the plan is overpriced. However, this does not document reasonableness.

When each service provider is examined against its benchmark group, the plan sponsor may discover that the investment adviser was:
• actually priced lower than the comparative benchmarking group,
• the investment managers were priced higher, and/or
• the administrative recordkeeping services were priced higher. Still, this does not provide documentation of reasonableness.

An investment adviser that was priced lower than its statistically viable benchmarking peer group may actually be overpaid if it has provided few or no services to the plan. On the other hand, it may truly be underpaid if it has provided substantial services, has acted as a fiduciary, and/or extends its services to include other functions, such as participant education. Reasonableness must be determined and documented in light of services provided.

Document Reasonableness for Administrative Recordkeeping Functions

Consider benchmarking the plan design features that drive recordkeeping costs. It costs more to keep records for a plan with such outsourced services such as tracking eligibility, handling auto-enrollment for all versus auto-enrollment for just new hires, or for a plan with a larger number of investment options.
• Document whether the plan design demands greater administrative attention. Is the plan more complex than its benchmarking peers?
• If so, it may be very reasonable to pay more in administrative fees.
• Review the plan design to make sure it is still in the best interests of plan participants.

When documenting reasonableness for the plan’s investment options, it is very important to consider more than just the total fees paid to the fund/option itself.

A Final Note. Plan sponsors must use their best efforts to obtain this fee information. In addition to the requirement that the sponsor report the provider to DOL, the Labor Department has also indicated that 401(k) plan sponsors must now terminate any service provider that fails to properly disclose its fees.

Not all fees need to be disclosed to participants. Certain plan expenses that are not charged directly or indirectly against the participant account balances would not need to be disclosed (e.g., administrative fees paid directly by the plan sponsor). One of the very first things a plan sponsor needs to do is to understand a 401(k) plan’s current fee, expense, and revenue-sharing arrangements.

The easiest way to do this, as discussed above, is to use a benchmarking service to reveal how the current fee, expense, and revenue-sharing structure compares with that of comparable plans, and then to document the process used to determine that fees comply with ERISA’s ‘‘reasonableness test.’’

Closing Thoughts: Caveat Emptor — Fiduciaries, Beware of New DOL Fee Disclosure Rules

Yes, DOL is on a mission to provide plan sponsors, fiduciaries, and participants with better information regarding plan fees. However, at the same time, these new rules and regulations have increased fiduciary responsibilities. Be aware that the rules have not only increased fiduciary duties but also can result in costly penalties for failure to take the proper action.

They may also subject a fiduciary to greater liability through a combination of DOL enforcement actions and potential litigation. Schedule C is a fiduciary responsibility, and signing the 5500 confirms not only that the information is correct and complete but that providers that have been paid have done the work and at a reasonable cost.

The new 408(b)(2) regulation will require fiduciaries to confirm that all covered service providers have delivered sufficient detailed fee and service information to document reasonableness under ERISA’s exclusive benefit rule. The disclosure regulations under ERISA Section 404(a)(5) are entirely a fiduciary responsibility and not the responsibility of the vendors.

This, once again, subjects plan sponsors to increased liability if participant fee disclosures are incorrect, unreasonable, or not delivered properly. Perhaps it is not so much caveat emptor as fiduciaries, beware!

Robert J. Rafter is NAPA Net’s ERISA Portal Conductor. Dorann J. Cafaro is senior VP of Fiduciary Benchmarks Inc.

Reproduced with permission from Pension & Benefits Daily, 108 PBD, 6/6/12, 06/06/2012. Copyright 2012 by The Bureau of National Affairs, Inc. (800-372-1033); http://www.bna.com.

Add Your Comments

One Comment

  1. Dorann Cafaro
    Posted October 20, 2012 at 7:09 am | Permalink

    An increase in DOL audits has been noted by both plan sponsors and advisers. One of the focuses of these audits is the “proof of reasonableness”; have your fee disclosures organized, make sure they represent disclosures from all service providers, and document what steps you have taken as a fiduciary to document their reasonableness. The liability is directly tied to financial penalties for failure to have acted per ERISA to assure your service providers are providing all necessary services in the best interests of the participants at a reasonable cost. These audits are not restricted to large plans; they are being experienced by many small and mid-size plans. Consider performing a pre-audit check for fiduciaries, both current clients and prospects.

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